The huge fuel subsidies: How to bite the bullet

The huge fuel subsidies: How to bite the bullet

Martin Jenkins, Jakarta

In Indonesia, much debate has recently centered on how the
government should tackle the problem of rising fuel subsidies as
the price of crude oil on the international market moves ever
higher.

At first glance, one may wonder how the government will cope.
After all, fuel subsidies are now set at Rp 63 trillion (US$7
billion) for 2004, far higher than the initial target of Rp 14.5
trillion. This increase is based on a higher oil price assumption
of $36 per barrel vis-a-vis $22 per barrel previously to reflect
the latest price movements on the international oil markets. Yet
even this assumption may prove to be too optimistic given the
rising price of oil, which has even exceeded the psychologically
significant level of $50 per barrel in recent weeks.

However, the higher fuel subsidies only give rise to a much
more modest increase in the budget deficit (to Rp 26.3 trillion
compared to the Rp 24.4 trillion previously estimated. As a
percentage of gross domestic product (GDP), this is only an
increase from 1.2 percent to 1.3 percent. After all, the modestly
higher deficit can easily be plugged-- either through foreign or
domestic financing. And the size of the deficit is unremarkable:
it is well below the 3 percent maximum budget deficit limit
imposed on European Union countries, for example.

But is it really good policymaking to continue to heavily
subsidize fuel? From a social and environmental perspective it is
not. The fact is that just as consumers of yesteryear puffed on
cigarettes unaware of the health risks involved, the general
public today is deluded into believing that these subsidies are
good for them. They could not be more wrong.

Firstly, fuel subsidies are largely enjoyed by the rich --
especially car owners of course. The unfairness of the fuel
subsidy policy can be seen in the fact that the more gas thirsty
your car is, the more you benefit from fuel subsidies! If you are
fortunate enough to own a large SUV or luxury saloon you will be
benefiting considerably from the fuel subsidies.

At the current gasoline selling price of Rp 1,810 rupiah per
liter, each motorist is probably being subsidized around Rp 2,600
rupiah for each liter of fuel they consume (assuming that premium
gasoline if unsubsidized would sell at Rp 4,400/liter). If a
Jakarta motorist consumes say 200 liters of gasoline in a month,
then they are being subsidized to the tune of Rp 520,000
rupiah/month, or more than the national monthly minimum wage in
most provinces of Indonesia!

In addition, fuel subsidies do not encourage conservation of
what is ultimately a scarce and nonrenewable resource. When a
liter of fuel costs less than a liter of mineral water from the
local supermarket what is the incentive to use fuel in a frugal
manner?

It should also not be forgotten that the burning of fossil
fuels causes massive damage to the environment. Take a look at
Jakarta. The huge number of vehicles on the city's increasingly
congested roads has made the nation's capital city one of the
most polluted cities in the world. Ultimately we all suffer
through health problems such as respiratory ailments not to
mention the stress from sitting in soul-destroying traffic jams
day after day. Is this what we want for our children?

As such, many governments around the world take the decision
to tax fuel, and to tax it heavily. The substantial proceeds that
can be raised through these taxes can then be used to develop a
decent, clean and efficient public transportation system --
something that Jakarta's long-suffering residents would certainly
benefit from.

Another concern is that higher fuel subsidies provide an even
greater incentive to smugglers who stand to make handsome profits
by illegally exporting fuel products to neighboring countries
such as Singapore. Given Indonesia's vast coastline and poor law
enforcement it is likely that a lot of subsidized fuel leaves the
country this way.

But even though fuel subsidies are misdirected, unfair, costly
and lead to the misuse of a scarce resource, the government still
has to be very careful in how it goes about eliminating them. To
simply discontinue the policy of subsidizing fuel would most
likely lead to disaster. Why would this be so?

Firstly, inflation would soar. According to economists at
Danareksa Research Institute (dRI), inflation would rise by 0.70
percent for every 10 percent increase in the price of fuel. If
then, the fuel subsidies were immediately eliminated and say the
price of gasoline doubled (a conservative assumption given that
premium gasoline is sold at Rp 1,810/liter, or way below its
current estimated market price of around Rp 4,400), Indonesia's
annual inflation rate could conceivably rise from between 6
percent and 7 percent to an astonishing 13 percent to 14 percent.

Higher inflation -- especially in transportation prices --
could have devastating consequences. Strikes, public protests and
even riots could easily ensue, as was the case when the IMF
advised former president Soeharto to hike fuel prices sharply as
the financial crisis unraveled in 1998.

The decision to hike fuel prices contributed significantly to
the social and political unrest that brought about his downfall.
Nigeria is another good case study: That country saw widespread
chaos when its government tried to end subsidies on refined oil
products in 2003.

And with the higher inflation, it should also be realized that
the cost of financing government floating rate bonds (which total
around Rp 225 trillion) would also increase dramatically. As
such, the government might not save as much as it had at first
expected by taking the decision to end the fuel subsidies.

Besides surging inflation, such a severe shock on the economy
-- arising from hiked fuel prices -- would likely hammer investor
confidence. This could lead to plummeting share prices on the
Jakarta Stock Exchange and a run on the rupiah as capital flows
out of the country. All in all, the economy would be badly hit
and the current upward growth momentum could be lost.

Given these considerations the government appears to be stuck
between a rock and a hard place: Lifting the oil subsidies at
once would likely lead to social unrest and economic catastrophe
whereas maintaining the subsidies is inappropriate given they are
misdirected, costly and ultimately unsustainable.

As such, the best solution may be to take the middle way: That
is to lift subsidies gradually and in phases, but not too
quickly, so as to avoid a large shock on the Indonesian economy
but also to ensure fiscal sustainability. dRI's model shows that
a 20 percent cut in the size of fuel subsidies each year for five
years would mean that the nation's budget would be in good shape
in the coming years.

In addition, better targeting of subsidies and educating the
general public to appreciate that fuel needs to be used frugally
are also very important.

But even though higher fuel prices are inevitable, people have
little reason to complain. After all, it does not make much sense
if fuel is cheaper than water, does it?

The writer is Market Analyst at the Danareksa Research
Institute. He can be reached at martin@danareksa.com.